Our investment philosophy is simple: We recommend MLPs with strong cash flows that are able to boost their distributions over time. No sector is immune to periodic selloff in the broader market, but, as long as the underlying businesses of our favorite MLPs are intact, we regard such corrections as outstanding buying opportunities.

The fear during May’s selloff was palpable, likely because memories of the vicious 2008 credit crunch are fresh in investors’ minds. And the early May “flash crash” represented another significant blow to confidence. But the worst thing investors can do during pullbacks is to panic and sell; those who held or added to their positions in MLPs in May have been rewarded–most now trade near their April highs.

The May selloff is also a perfect example of why we don’t recommend the use of stop-loss orders or trailing stops for MLPs. As we explained in the May 14, 2010, issue, The Right Numbers, the use of stops often causes investors to sell their positions at extraordinarily unfavorable prices.

We recommended buying the dip in several issues of MLP Profits over the past two months. Long-term investors should consider adding to their positions in our favorites over time, keeping some cash in reserve to deploy during future pullbacks.

It’s not too late to buy into our favorites because the recent rally in the MLPs is supported by improving fundamentals.

One of the most important catalysts to watch is the credit markets. The main fear that drove the selling in MLPs in May was that volatility in EU sovereign credit markets–primarily for issues from Greece, Italy, Spain and Portugal–would lead to a credit freeze similar to what transpired in autumn 2008.

For MLPs, high and rising distributions–the equivalent of dividends–are key performance drivers. MLPs grow their payouts in two main ways: acquisitions or organic growth projects.

Both growth strategies require capital: The heavy, fixed assets MLPs own generate ample and dependable cash flows but require large up-front investments to build. And buying assets or other MLPs can be expensive, particularly in healthy market environments.

MLPs raise capital in two ways: by issuing additional units (stock) or by taking on debt. In autumn 2008, both sources of capital dried up. Equity markets were too weak to support sales of new units, and the bond and bank lending markets ground to a halt after Lehman Brothers declared bankruptcy. The credit crunch was a more important driver of downside in MLPs back in 2008 than the recession or falling commodity prices.

As we explained in the May 24, 2010 issue, Credit where Credit is Due, even at the height of the credit market panic in May global debt markets were far healthier than during the credit crunch of 2008. This was particularly true for stable cash-generative businesses like MLPs; we highlighted several MLPs that managed to sell bonds right into the teeth of the May selloff at extremely attractive interest rates. In fact, Enterprise Products Partners LP (NYSE: EPD) and Kinder Morgan Energy Partners LP (NYSE: KMP) paid less to borrow money in May than they did last autumn–proof positive that capital is easy to come by for MLPs despite the broader market selloff.

Since late May, global credit markets have continued to improve markedly. One useful metric is to look at the yields on corporate bonds rated “BBB” compared to US Treasury bonds of a similar duration.

Source: Bloomberg

To calculate this chart, I compared yields on 10-year bonds of Industrial companies in the US rated “BBB” to the rate on 10-year US Treasury Bonds. The current spread is roughly 2.35 percent, meaning that a corporation rated BBB by Standard & Poor’s can be expected to pay an interest rate on its bonds of around 2.35 percent more than the US government pays on its 10-year bonds.

The BBB spread did spike slightly as the EU credit crisis unfolded in late April and early May but never came close to the elevated spreads that prevailed during the 2008 credit freeze. Moreover, spreads have drifted slightly lower over the past few weeks.

Even more impressive, the actual yield on BBB-rated debt is around 5.35 percent–yields broke to a new low in late June. The only reason this graph of the spread isn’t falling is that investors have been buying 10-year US government bonds as a safe haven against broader market conditions. The declining yields on Treasuries have kept pace with falling yields on US corporate debt.

Lower yields on BBB-rated bonds indicate that investors are eagerly buying corporate bonds, even issues from companies which have less-than-perfect credit ratings. The yields on these bonds are hovering near 2010 lows. In short, the cost of credit is extremely low.

And it’s not just the interest rates on bonds that are improving. In May US corporations issued just $35 billion in bonds, roughly one-third the average issuance in the first four months of the year. This statistic was the subject of countless sensationalist headlines in the media about global credit markets.

But US debt markets bounced back in June, when US companies issued more than $69 billion in bonds–roughly double what they issued in May, and a solid showing for what’s normally a quiet month.

Other key catalysts we’ve covered before in MLP Profits include the interbank lending market and the TED Spread. The TED spread is calculated by subtracting the yield on three-month US government bonds from the three-month London Interbank Offered Rate (LIBOR). LIBOR is the interest rate that banks charge to lend money to one another; a spike in LIBOR suggests that banks are becoming more cautious and the financial system is under stress. Here’s a graph of the TED spread.

Source: Bloomberg

This chart tracks TED Spread from the end of 2007. The TED Spread rose from its March lows to just under 50 basis points in late May and early June. But this is a far cry from the levels near 500 that prevailed at the height of the 2008 financial crisis.

And since early June, the TED Spread has drifted lower to less than 37 basis points. This decline in the TED Spread stems from a gradual reduction in LIBOR rates coupled and a rally in the yield on three-month US Treasury Bill. The rising yield on three-month Treasuries suggests that investors are reallocating money out of safe-haven, short-term government bonds and into riskier but higher-yielding corporate credits.

In May and early June the predominant bearish argument was that sovereign credit concerns in Greece, Spain and other countries on the periphery of the EU would spark another global credit crunch. This catastrophe failed to materialize, and panic in global credit markets has begun to subside. This is all great news for MLPs and has been a key driver of the upside in the Alerian MLP Index over the past month.

The Energy Business

The return of some measure of calm to global credit markets has been a big upside driver for MLPs. But encouraging fundamental developments in the energy business are also buoying the group.

For example, US demand for oil and refined products like gasoline is recovering steadily.

Source: Energy Information Administration

This graph depicts the four-week average of US demand for oil, gasoline and all other petroleum products. It’s clear that US petroleum demand began to slump at the beginning of 2008 for two main reasons: a vicious recession and sky-high energy prices in mid-2008.

But petroleum demand bottomed in 2009 and has recovered gradually. That oil prices have fallen in sympathy with stocks this summer also bodes well for demand in summer driving season.

Most MLPs have little or no direct exposure to oil prices. The only exceptions are production-oriented partnerships such as Aggressive Portfolio holdings Legacy Reserves LP (NasdaqGS: LGCY) and Linn Energy LLC (NasdaqGS: LINE). But even the producers’ exposure to prices is limited because most MLPs use hedges to lock in prices for years into the future. Furthermore, with crude oil still trading at roughly $70 a barrel, we see no real risk to these company’s cash flows. Both Legacy and Linn survived the 2008 commodity price collapse without cutting their distributions–an impressive feat during the toughest oil market in decades.

However, some MLPs do have sensitivity to volumes. Conservative Portfolio holdings Kinder Morgan Energy Partners and Sunoco Logistics Partners LP (NYSE: SXL) own pipelines that carry oil and refined products to and from refineries. These firms also handle the storage and blending of crude and refined products at terminals around the US.

Typically, fees paid to pipeline operators include a minimum, plus an additional fee based on the volumes of oil and refined products traveling through their systems. It’s the amount of liquid that counts–not the value of that liquid. All of these companies will benefit from rising demand for oil because supplying that demand will necessitate moving more petroleum through pipelines and more blending.

 An even more important fundamental to watch for the MLPs is the value of natural gas liquids (NGL), a commodity we explained at great length in the March 15, 2010, issue of MLP Profits, MLPs and Natural Gas Liquids.

To summarize, natural gas is primarily composed of methane but also includes a long list of other hydrocarbons such as propane, butane and ethane. These other hydrocarbons are collectively known as NGLs; the value of a barrel of NGLs tends to track the price of crude oil far more closely than that of natural gas.

NGL production is important for several reasons. First, Portfolio recommendations Targa Resource Partners (NYSE: NGLS) and Enterprise Products Partners own gas processing facilities used to separate NGLs from raw natural gas. Both firms also own fractionation facilities that are used to separate a barrel of mixed NGLs into its constituent products.

Strong demand and pricing for NGLs also has supported US drilling activity this year. More drilling activity spells more gas and NGLs to transport, process and store–and higher cash flows for MLPs. Demand for NGLs has remained firm this year thanks, in part, to strong demand for ethane from petrochemicals processors.

Ethylene is a key petrochemical that’s the building block of most plastics. The chemical can be synthesized either from naphtha, a hydrocarbon refined from oil, or ethane, an NGL. Crude oil prices are high relative to the price of natural gas; in fact, the ratio of oil to gas prices is near record levels. That means that petrochemical producers currently heavily favor the use of natural gas and ethane to make ethylene.

With gas prices still depressed, one might expect US gas drilling activity to fall. But the opposite has occurred: Nearly 960 rigs are drilling for natural gas in the US, up from about 750 at the beginning of the year. The reason for the increase in drilling activity is that many of the big US unconventional shale plays also contain significant quantities of NGLs. Giving strong demand and pricing for NGLs, producers can continue to drill profitably.

Despite all the sensationalist headlines about slowing global growth, credit market conditions for the MLPs are strong and fundamentals support further upside for the group.